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Basic Principles of Business Valuation You Should Know



Basic Principles of Business ValuationEverything has a value. Putting value in dollar terms is the cornerstone not only of running a business but also of investing in almost any form. Knowing how to arrive at a value for the physical and intrinsic characteristics of a business is essential to building wealth of all kinds. To that end, people who invest in companies need to look beyond the current state of the business they own (or want to own) and consider what decisions they need to make to boost value. People who have experience in those industries are often best equipped to make those decisions, but it often helps to engage a business valuation expert for guidance.

In this post, I discuss the concept of value and note some of the main principles of business valuation. You’re here for one of two big reasons: You have a business that you want to sell, or you want to buy a business. Very likely, the business in question is a small business (with less than $3 million in annual sales), and it may be the first and only business you ever own. Before I go further, I want to pay you a compliment. Right now, you’re doing something that painfully few entrepreneurs do: thinking about what a company is actually worth before you make a major decision or take a major action. You’re already ahead of the game. And because you’re reading this post, you obviously know that business valuation is an important part of that game. Read on…




Value Differs From Price

As the celebrated investor Warren Buffett once said, “Price is what you pay. Value is what you get”.

In business deals, most buyers and sellers have a singular focus on price —and price is hard to avoid. Negotiations ideally produce numbers that both sides can be happy with. But getting to the right price in any deal involves understanding what business assets are truly worth and then structuring a deal around financing and tax realities, which can be quite surprising to those who fail to plan.


Planning Drives Value

Creating value is a transformative topic in business planning and execution. If you’re creating a product, granted, that product is the focus of the business for customers and your employees. Creating value — long-term growth in asset value in a company you’ve built — is something you need to focus on, because a company is the sum of real and tangible assets, investments, ideas, and management talent.

If you can look at all those working parts of a business through the prism of value, the desire to determine and create value in a company can become a much more important driving force in its growth than simple profits and losses.

Proper valuation takes time. People buy and sell businesses for a variety of reasons that aren’t all about business. For instance, they may make moves in and out of companies based on career goals. Others devote a lifetime to a business so they can finance their retirement or simply pass the business on to their kids as a legacy. All these motivations drive valuation and should require three to five years to account for owners’ estate, succession, and exit planning.


No Two Valuations Are Exactly Alike

No two businesses are exactly alike; neither are the goals and circumstances of business owners. You may be in any of a variety of situations, such as the following:

  • You may be the child of a company founder, wondering whether you want to take over the company when she retires.
  • You may be a corporate executive who’s ready to start a new career with a new business purchased with a cash buyout.
  • You may be a worried sibling trying to figure out what to do with the family company because the company’s founder, your father, has died suddenly.

Valuation isn’t an exact science for another reason as well: The risk inherent in any business situation is far from static.

Depending on the economy and the state of the industry the business operates in, the company may be under tremendous pressure to stay afloat, or it may have great opportunities for growth. Any time the economy goes through a major convulsion, people take a fresh look at what value means and at the realities of any deal. As I write this post, the nation is in the grip of a worldwide credit crisis — an economic slowdown that is redefining the values of a host of assets, from companies to private homes.

All these variables are one reason you won’t emerge from this post with the skills to do a top-to-bottom business valuation. Also, proper business valuation takes a lot of practice. People with finance degrees and long experience in accounting or other numbers-related fields aren’t always naturals at valuation, either. Don’t worry, though.


Valuation Isn’t A One-Time Deal

If you’re already operating a business to its fullest potential, valuation isn’t something you should put off until you’re ready to sell or close your doors.

Most tax, business, and personal finance experts say that even if you’re years away from retirement — or years away from your next business idea — keeping your valuation numbers current is a good idea. This way, you can make changes and investments in the business so you can leave the business with the highest valuation possible.

A strategy of continual valuation tells you the following things:

  • Whether selling your business or merging with another makes sense
  • Whether you can make enough money from the sale of a business to support your retirement
  • When you want to set a timetable for your kids or other family members to take over the business
  • The optimal time to set up an employee stock ownership plan (ESOP) as a way to pull money out of the business in a tax-advantaged way



How Often Should You Run Valuation Numbers?

Frankly, it varies based on need. With computerization, it’s easy for many businesses to program their numbers so they can keep a constant eye on their main value indicators that have been developed for any goal they have on their radar. If you’re working with a business or tax planner, discuss the creation of a valuation system for your business, whether it’s something you access yourself or have an expert handle at regular intervals.

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